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Global Economic Research

June 11, 2010

Highlights
The Week — Same, but different. Business cycles share common features, and this one is no different. But this cycle also has a number of different features that are reshaping the global outlook. Canada — The hot housing market chills a bit. United States — U.S. retail sales hit a speed bump in May, highlighting shaky consumer sentiment. International — Benchmark interest rates on hold in the euro zone and the U.K.

Scotia Economics
Scotia Plaza 40 King Street West, 63rd Floor Toronto, Ontario Canada M5H 1H1 Tel: (416) 866-6253 Fax: (416) 866-2829 Email: scotia_economics@scotiacapital.com
This Report is prepared by Scotia Economics as a resource for the clients of Scotiabank and Scotia Capital. While the information is from sources believed reliable, neither the information nor the forecast shall be taken as a representation for which The Bank of Nova Scotia or Scotia Capital Inc. or any of their employees incur any responsibility.

Weekly Trends is available on: www.scotiabank.com, Bloomberg at SCOE and Reuters at SM1C

a significant compression on costs and expenditures, profitable businesses are again moving to expand output, productive investments, and hiring. And consumers are again in a buying mood, taking advantage of discounting, low borrowing costs, and an important stabilization in financial well-being. While most of these traditional factors should continue to support the expansion, one of the different aspects of this recovery is that the developing countries are playing a much greater role in the global economy’s revitalization. There has been a much greater focus in these nations to promote domestically-generated activity that in turn has buoyed commodity prices and expanded imports. Collectively, these large and heavily-populated developing nations can be expected to remain the key drivers of global growth, especially since many of the developed nations must beef up their savings, investments, and exports. This ‘rebalancing’ — from surplus to deficit nations — is critical to the magnitude and sustainability of the recovery, and must continue to be nurtured during the unprecedented period of deleveraging underway in the United States, the U.K., throughout Europe, and even Japan. In the same, but different category, are the policy responses that the developed nations pursue to rebalance their own economies. In the past, relatively small counter-cyclically induced fiscal imbalances were eventually reduced or eliminated by renewed growth. However, fiscal adjustments have taken on a greater sense of urgency in the wake of the sovereign debt crisis that has enveloped Europe. Throughout the region, the transition from fiscal stimulus to consolidation is being brought forward, with spending cuts and restraint supplemented with revenue enhancing measures. With inflation pressures evaporating under the weight of slow growth and fiscal drag, normalizing ultra-low interest rates has been put on hold. Monetary policy favours unconventional easing, and euro/sterling depreciation has become a relief valve. Eventually, the United States will likely be forced to move accordingly, since repeated trillion dollar deficits may be on the verge of becoming counterproductive if consumers, businesses, and investors believe that a growing tax burden will overpower expenditure restraint. ■

aron_gampel@scotiacapital.com

Same, But Different
Business cycles follow a typical pattern. Recessions, and the rare depressions, eventually trough, and recoveries ensue. At some point, output growth peaks, and the cycle re-plays. The confidence, earnings, and spending of consumers and businesses increases and then decreases. Co-incidentally, a similar pattern emerges for prices, where inflation pressures eventually build upon disinflation or even deflation trends until macro-economic and policy conditions change. Public policy shifts from firming and tightening, to easing, and then back again. Investors typically lead the cycle shifts, selling as the economies turn down and then buying as the cycles turns up. This cycle is no different, but at the same time, it is. Although the recession was deep, and virtually every region was impacted to varying degrees, the economic toll was most evident in the developed world. The United States was again a major drag on global economic activity, but was joined by a number of European countries that also suffered from debt overload. But unlike past U.S. housing/real estate cycle busts which pulled down a bank — Franklin National, First Penn, Continental Illinois, and the myriad of S&L firms — this cycle was noteworthy because of the simultaneous failure of a number of large financial institutions, not only in the United States, but throughout Europe as well. The resulting shortcircuiting of credit flows internationally probably did as much, or even more, to drag the rest of the world down than just the trade-related consolidation that would have normally occurred. Exaggerated policy responses — generational lows in short-term interest rates and massive fiscal deficits — were needed to reverse the severe economic and financial strains. And although the ensuing rebound has been comparatively more moderate than prior cyclical recoveries, the results have generally been in line with past performances. Countries that were least impacted by the implosion in real estate and banking are the ones that are experiencing the strongest recoveries in domestic demand, though external trade is being constrained by the deleveraging underway in the United States and in many European nations that is dragging on these respective countries. An inventory restocking cycle has helped to generate the renewed and stronger momentum that is helping to revive the global economy. After

Neil Tisdall (416) 866-6252 neil_tisdall@scotiacapital.com Review
Merchandise Trade — Canada reversed its trade deficit into a surplus in April due to price related declines in imports, as volumes were up for both imports and exports for the third consecutive month; the trade balance moved from -$236 million to $175 million. Imports fell at a faster pace than exports, at -2.2% m/m and -1.0% m/m respectively. Exports to the United States grew 0.7% m/m or by $177 million, but that was not enough to balance out a sharp 47.1% m/m decline in exports to the U.K., which is $880 million less than in March. Imports from the United States also grew on a monthly basis, by 0.9%, but this was also against the trend, as declining imports from the rest of the world dragged the overall figure into the negative. Capacity Utilization — Canadian industries continue to ramp up their capacity use, though the 2010Q1 rate was still well below normal, pre-recession levels. Industries were operating on average at 74.2% of capacity, up almost 3 percentage points from the previous quarter, and up over 6 percentage points from the 2009Q2 low. The manufacturing sector had a strong quarter, increasing from 70.7% to 75.0%. Manufacturing capacity utilization is rebounding from a decades low 65.5% reading in 2009Q2 thanks to improving domestic and international demand. Of the subsectors, computer and electronics manufacturing increased the most, jumping from 89.1% to 95.8%.

Canada’s Hot Housing Market Chills A Bit
Softening resale markets and pricing are beginning to spill over to the new home market. Housing starts eased back to an annualized rate of 189,100 units in May, down from an average of roughly 200,000 over the prior three months. Starts were lower for both single-family and multi-unit residences, and in all regions of the country with the exception of Atlantic Canada. While a bit weaker than expected, the report is largely consistent with recent residential permit data which suggest the pace of new residential construction is peaking after a steady recovery over the past year.
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Builders are responding to shifting resale market conditions, which help to determine the relative demand and pricing for new homes. While resale markets remain quite healthy, they have nonetheless become much better balanced in recent months alongside some softening in demand and a sharp rise in listings. Some centres, including Vancouver and Calgary, are already beginning to favour buyers over sellers, while others such as Toronto are becoming far less competitive.

This in turn will begin to erode new homebuilders’ pricing power, and the incentive to add additional inventory. Average selling prices for new homes have been edging up steadily since last summer amid tight resale market conditions. Statistics Canada’s index of new home prices (NHPI) rose 0.3% m/m (+2.5% y/y) in April, matching the prior month’s increase. A number of factors are combining to cool off Canada’s housing market, including modestly higher interest rates, reduced affordability as a result of significant price increases in recent years, slightly more restrictive lending criteria, and the July 1st introduction of the HST in Ontario and British Columbia (transition rules applicable to new home purchases have been in place for some time). Both construction and sales remain at historically high levels, but we expect this cooling off

trend to continue through the latter half of 2010 and into next year, with the overall level of starts moving back towards its underlying sustainable demographic and replacement rate of about 175,000 units annually. (Statistical note: As the NHPI excludes value-added taxes, the HST shift will have no direct impact on the index. However, to the extent that builders pass on tax savings on building materials to consumers, it could lower the index. The house-only component of the NHPI (i.e. excluding land) feeds directly into the replacement cost shelter component of the CPI.) ■

Cautious Consumers Rein In Spending
Retail sales figures for May disappointed, with headline sales dropping 1.2% m/m. The past six months have marked a period of recovery for the sector, but May’s drop highlights the continued cautiousness of American consumers. Sales at building material stores and autos accounted for the bulk of the 106 decline, down 9.3% m/m and 1.7% m/m respectively, while clothing and apparel 104 sales slid 1.3% m/m. The dramatic drop 1991 at building material retailers was 102 2007 expected, as first-time home buyer tax 100 credits expired in April. Although the headline total sales figure is rather 98 Y-axis - Index (100=Start of Recession) negative, losses were not broadly based X-axis - quarters across retail segments. Eight of the 96 * Input for real GDP thirteen retail segments experienced 1 2 3 4 5 6 7 8 9 10 modest gains, and sales ex-autos, gas and building supplies climbed slightly by 0.1% m/m. Preliminary estimates from the International Council of Shopping Centers point to better results at chain stores and mall retailers in June, with Father’s Day arriving later in the month and warmer weather boosting traffic and clothing sales.
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Merchandise Trade — Both imports and exports shrank in April, with exports decreasing at a faster pace, widening the trade deficit to $40.3 billion. This is the largest trade gap there has been since the end of 2008 when the deficit was at -$41.0 billion. The decreases in imports and exports both follow months with large gains, so the drop-off is partially due to a correction of last month’s strength. Other factors that slowed U.S. trade were the credit troubles in Europe, which played towards lessening demand, and a stronger U.S. dollar relative to other currencies, making U.S. goods less attractive to foreign buyers. Wholesale Sales — Wholesales inventories increased 0.7% m/m in April, and sit poised to break into positive y/y territory. Total business inventories rose 0.8% m/m and are at -2.8% y/y, the smallest y/y decline since December 2008, while wholesale inventories are at -3.2% y/y. The wholesale inventory-to-sales ratio, which measures the time in months it would take to exhaust current levels of stock, dropped to 1.13 months, the lowest level in almost 20 years. This is due to slow sales and an unwillingness of companies to hold large inventories of goods (to the vexation of retailers), not because of strong sales and quick inventory turnover.

However, May’s results are a further indication that the recovery in retail sales will be measured and slightly volatile. Consumer loan data released earlier in the week showed households continuing to deleverage their balance sheets. Credit card debt fell 1% m/m, leaving total credit card debt outstanding at its lowest level since 2006. Tepid employment growth and Europe’s debt woes added further nervousness and prompted consumers to increase personal savings by 16% in April — raising the savings rate 50 basis points to 3.6%. While far more confident than last year, a large share of consumers are still carefully managing their budgets and hunting for bargains, as evidenced by continued positive sales results at discount retailers.

Overall, May’s decline will likely prove to be a small deviation off a continued period of growth for the sector. However, it serves as a reminder that the recovery will be rocky until more pronounced employment gains materialize and household debt is brought down to more comfortable levels. ■

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Global Economic Research

June 11, 2010

Europe
Tuuli McCully
(416) 863-2859 tuuli_mccully@scotiacapital.com

Hungary Confirms Its Commitment To IMF-Supervised Fiscal Target
Concerns regarding Hungary’s fiscal situation are easing following increased turmoil at the end of last week when officials of the new governing Fidesz party hinted that the country’s public finances are heading for a Greece-like crisis. Prior to the April elections, the Fidesz campaigned for a speedy economic recovery, emphasizing that restoring economic growth should have a priority over improving government finances. Following the turbulence (intentional or not), the administration reversed its course regarding its policy ideals and campaign promises. On Tuesday, the government outlined an austerity plan — which includes a revamp of the tax system and cuts to the public sector — in order to be able to meet this year’s fiscal deficit target of 3.8% of GDP, as agreed under the country’s IMFsupervised economic program. Hungarian monetary policy makers left their benchmark interest rate unchanged at 5.25% last week after reducing it on a monthly basis since July 2009. The Hungarian economy is showing stronger signs of recovery than earlier expected; real GDP increased by 0.9% q/q and 0.1% y/y in the first quarter of the year. According to the monetary authorities, CPI inflation is unlikely to fall below the central bank’s 3% target, but to settle around it in the medium-term. Inflation slowed to 5.1% y/y in May from 5.7% the month before.

Euro Zone & U.K. Benchmark Interest Rates On Hold
The European Central Bank (ECB) and the Bank of England (BoE) left their benchmark interest rates unchanged at 1.0% and 0.5%, respectively, following their policy meetings on Thursday. The ECB will continue with unlimited funding operations as well as government and corporate bond purchases, while the BoE maintained the asset purchase program target at £200 billion. The policy decisions indicate that authorities maintain their view that economic recovery prospects remain somewhat fragile, requiring continued support from an accommodative policy stance before emergency stimulus measures can be withdrawn. In announcing the ECB’s decision, President Jean-Claude Trichet noted that economic recovery will be uneven across 2.5 euro zone economies and sectors, while the 2.0 financial environment is characterized by “unusually high uncertainty”. Nevertheless, 1.5 Trichet maintained his view that euro zone ECB interest rates remain “appropriate”. 1.0 Although the observation was a repetition 0.5 from previous months, it turned out to be BOE euro supportive as market participants 0.0 Jan-09 Jul-09 Jan-10 Jul-10 interpreted it as an indication that the ECB is not considering additional stimulus measures. According to Trichet, inflationary pressures will remain contained; a flash estimate for euro zone inflation shows that consumer prices increased by 1.6% y/y in May, a slight acceleration from the 1.5% y/y rate recorded the month before, but remained comfortably within the ECB’s target of “below, but close to, 2%”. The ECB assesses that output will continue to expand at a moderate pace this year, with a growth rate ranging between 0.7% and 1.3%. The forecast range for 2011 was revised downwards to 0.2%-2.2%. Due to the increased uncertainties stemming from the ongoing crisis in highly indebted euro zone economies, we have revised our expectations regarding the beginning of the euro zone monetary tightening cycle and expect the first interest rate hike to take place in the final quarter of 2011.
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In keeping with normal BoE practices when there is no change in policy, there was no further explanation of the decision to maintain the Bank Rate at 0.5% and the asset purchase program at £200 billion. We expect the BoE to keep the benchmark interest rate at the current level until the second quarter of 2011. The central bank will be challenged by the task of finding a balance between restoring growth and limiting inflationary pressures; consumer price inflation accelerated to 3.7% y/y in April. Monetary authorities expect the increase in price pressures to be temporary, with inflation easing over the course of the year. While the outlook is complicated by the impact of increased indirect taxes and higher inflation expectations, the rebound in oil prices and sterling weakness will also slow the disinflation process. While a gradual economic recovery is taking hold in the U.K., we expect the country’s output to remain below the long-term norm, with real GDP expanding by around 1% through 2011 following a 4.9% contraction in 2009. ■
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Markets — The European Central Bank unsurprisingly held its overnight interest rate steady at 1.0%, but the non-movement was followed by heartening comments by ECB president Trichet regarding an increased growth forecast for the euro zone for the remainder of 2010. The euro reacted positively to the comments by the President, and moved off its multi-year Monday low of 1.1923 against the USD, rising to 1.2124 on Thursday. The potential for depreciation of the euro below 1.19 remains if any more sovereigns declare policy difficulties in the fashion of Greece and Hungary. The Canadian dollar closed above 97 cents to the USD on Thursday, marking a 3% gain over four days, putting it on pace for its largest weekly appreciation since October 2009. At the time of writing, the loonie dipped below 97 cents due to Friday’s crude oil prices dropping nearly US$2/bbl from Thursday’s close of $75.48, but still remains a strong performer. US equities started the week strong, with the Dow breaking through the 10,000 mark on Thursday after closing at a low of 9,816 Monday, while the S&P 500 has gained over 2% since the beginning of the week. Friday’s weak U.S. retail sales data and ambivalent consumer confidence data didn’t drag down the main indices as much as they could have, but took a little lustre off the week’s momentum.
Note: Latest observation taken at time of writing.

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Fiscal Policy — Washington reports a US$136 billion deficit for May, US$54 billion narrower than a year earlier, though some of the improvement reflects technical adjustments. For the first eight months of fiscal 2010, the cumulative deficit is US$936 billion, only slightly narrower than the year-earlier shortfall, in line with our forecast of a US$1.38 trillion FY10 deficit that only slightly betters the FY09 deficit. The yearover-year decline in U.S. federal revenues, as measured by a twelve-month moving average, continues to contract (bottom right chart). For the twelve months ending May 2010, total revenues are just 6.5% below the year-earlier period, following double-digit decreases from April 2009 to March 2010. In Canada, data for the twelve months of fiscal 2009-10 (ending March 31 before Supplementary Period adjustments) indicated a 5.5% revenue decline. Upcoming: Meeting of federal, provincial and territorial Finance Ministers on June 14th. Among the issues for discussion is pension reform.